Recent Economic Developments, Outlook and Risks

1. The external environment relevant for the Chilean economy remains very favorable. In a context of high and more balanced growth of the global economy, copper and oil prices have reached record-high levels during the first half of 2006. Notwithstanding the recent correction of stock and commodity prices in the global market, Chile’s external conditions are clearly supportive.

2. Coherent with the transitory nature of these positive developments in terms of trade, the current account will post a surplus this and next year. In line with this evaluation of external conditions and following the gradual normalization of monetary policy, domestic demand and GDP growth have moderated in the first two quarters of 2006, getting closer to their medium-term growth path. Moreover, during the second half of the year, latest output indicators point toward a somewhat lower increase in growth rates than what was previously considered around the time of IMF mission to Chile. Meanwhile, wage-based employment continues to increase relatively vigorously, but our authorities are aware that drawing strong conclusions on unemployment trends, employment growth, productivity and unit labor costs is very difficult at the time, due to methodological changes in the official labor survey implemented during the first half of 2006. Nevertheless, Chile’s National Institute of Statistics (INE) is working on methodologies to make the data comparable.

3. Headline inflation is currently at the top of the target range, and the Central Bank considers that it will converge to the center a few quarters ahead, once one-off higher fuel prices effects fade away. Measures of core inflation—that exclude fuels, perishables and some regulated utilities—and of inflation expectations are well-anchored around 3 percent. While fuel prices have continued on the rise, the rate of increase in aggregate wages has eased in 2006, bringing about well behaved unit labor costs pressures.

4. The external environment, coupled with Chile’s strong monetary and fiscal fundamentals, should continue to support growth in 2006-2007. The Chilean economy is widely expected to grow in the range of 5 to 6 percent over the next two years – roughly in line or slightly above with the expansion in potential output. In this respect, the key risks for the outlook of the Chilean economy remain largely external and broadly balanced, related, on the downside, to the uncertainty in commodity prices—specially further oil price increases—, abrupt increases in international interest rates and its subsequent negative effects on emerging market investors sentiment; and the uncertainty regarding the evolution of house prices in some important industrial economies. On the upside, a more favorable development could result from growth of the global economy and the continuation of high copper prices. In addition to these risks, the staff also suggests that disruptions in the gas supply from Argentina could lead to an upward adjustment of production costs, with negative implications for domestic demand and growth. However, our authorities consider that the extensive conversion process to alternative energy sources that has taken place, plus the recent negotiations with Argentine authorities, ensure a moderated impact.

5. Against the backdrop of domestic financial conditions still expansionary, our authorities’ assessment is that the risks for the financial stability are reduced. First, Chile’s financial system is profitable, well-capitalized with historically low levels of non performing loans, and effectively supervised and regulated. Second, the corporate sector and households’ balance sheets are in solid position. And third, the risks of accessing to external funding are low, since Chile’s economy has no external financing needs in 2006-07, the external debt ratio has continued its improvement in the first half of 2006, while corporate and banking sectors have appropriately hedged their currency risks. Moreover, the Central Bank of Chile’s (CBC) foreign reserve adequacy ratios, together with the external assets accumulated by the government due to high copper prices, provide an additional buffer against external shocks.

Macroeconomic Policy Stance

6. Chile’s monetary policy framework–a target of 3 percent ± 1 percent for the inflation rate, together with a floating exchange rate–continues to serve the economy well. The CBC has pursued a cautious and pragmatic approach by withdrawing monetary stimulus, consistent with the goal of maintaining inflation around 3 percent over the policy horizon of 12 to 24 months. Since September 2004, the CBC has raised its policy rate by 350 basis points to 5¼ percent. Given its view that the economy is presently operating with little or almost no slack, the CBC considers that, in the most likely scenario, further gradual rate hikes would likely be necessary to bring inflation closer to the target, but new policy rate changes will be data-dependent and will probably be less frequent than in previous quarters. The monetary policy stance is clearly understood by the private sector, as it is reflected in, foremost, well anchored inflation expectations around 3 percent, and widespread expectations that further gradual rate hikes lie ahead. The market remains divided on the frequency and extent of further interest rate adjustments, with some participants arguing that the monetary tightening cycle might be coming close to an end.

7. Thanks to the copper price windfall and the adherence to the rule of structural surplus, fiscal policy is expected to reach a significant increase in the surplus in 2006 to around 6 percent of the GDP. This will allow further reduction of both the government’s gross and net debt ratios to levels compared favorably with those of economies with similar sovereign risk grade. The strong position of public finances provides the economy enough flexibility to adjust quickly in the face of possible deterioration of the external environment. As the staff has explained in their report, government authorities are mindful of the expansive effect on spending of high cooper prices in 2007 and are committed to manage this revenue windfall prudently. In particular, to avoid Dutch-disease like effect, the authorities are planning to give priority in the 2007 budget to spending recomposition towards spending outlays with high tradable content.

Government’s Structural Goals

8. After twenty years of continued high expansion of GDP per capita averaging around 4.1 percent per year during 1991-2005 to reach about US$ 7 thousand per person, Chile has registered significant distributive and poverty changes in the last fifteen years, which is mainly reflected in a reduction of poverty incidence from 45 percent in 1987 to 19 percent in 2003. Nevertheless, Chile still belongs to the group of middle-income emerging economies which face vulnerabilities from external shocks. Mindful on this reality, the new administration has emphasized that Chile faces two challenges looking forward: ensuring conditions for sustained growth in an increasingly flexible economy while guaranteeing a wide network of social protection for citizens.

Boosting Productivity and Growth

9. In order to maintain and to deepen Chile’s favorable economic outlook beyond for 2006-07 and reach sustained growth in the long-term, it is important to build up and consolidate appropriate conditions for the entrepreneurship, with a special emphasis on the development of small and medium size enterprises (SME). This will lead to more investment and job creation while reducing social inequalities. Our authorities have taken concrete initiatives such as a tax debt relief for SMEs reaching up to 80 percent of interest and penalties, a gradual reduction of the stamp tax on debt reschedulings that take into account revenue collection, the establishment of a simplified tax system for SMEs, strengthening of the Fondo de Garantia para Pequeñas Empresas (FOGAPE)—a government fund that provides guarantees on bank loans to SMEs—by adding US$ 10 million to allow 46 percent more government-guaranteed loans to this sector, the enlargement of SME base of BancoEstado, Chile’s state-owned bank to reach 300 thousand customers by 2008, specific measures to strengthen the liquidity position of SMEs, the development of the risk and venture capital industry through the congressional approval of the Capital Market Reform (MKII) package.

10. Our authorities believe that strengthening innovation is also crucial to Chile’s long-term development. Macroeconomic stability, market-friendly FDI and trade regimes constitute important conditions for promoting innovation. But, Chile’s innovation activities are driven and funded by the public sector through a fragmented National Innovation System, which result in R&D spending of only around 0.7 percent of GDP. To overcome this drawback, our authorities intend to put in practice the recommendations of the National Innovation Council set up during the former administration, financed with the resources from the mining royalty which are estimated to reach US$ 150 million a year in steady state. In that direction, the government is committed to establish a 15 percent flat tax on the software and technology imports, and also has submitted to Congress a draft bill that establishes a 35 percent subsidy on R&D spending carried out by companies together with universities and research centers.

11. Chile’s performance over the past decade is due to a large extent to the strengthening of pro-competition regulation in place. Taking further steps to promote market competition is another important challenge to boost productivity. In this area, the initiatives to be taken are related to strengthening the governance framework for free competition, by allocating more resources to the Office of the National Economic Attorney and the Court of Free Competition, setting up a new merger policy with penalties which discourage the risks of market collusion.

Building a Social Safety Net

12. The new administration is committed to developing an economic institutional framework that assures citizens a social safety net so as to complement steadily the efforts oriented to boost innovation and entrepreneurship. This protection framework is intended to be built upon two pillars. First, a macroeconomic policy framework oriented to strengthen the resilience of the economy against shocks. Second, a social policy focused on the creation of a social safety net.

13. Alongside the prudent management of the terms of trade boom and the reduced cost of external financing, the monetary, exchange rate—which includes the possibility of interventions in exceptional circumstances—and fiscal policy framework in place provides adequate shock absorbers that limit the economic and financial impact of a possible abrupt reversion of external conditions, particularly over the last several years, when the economy has been subject to a series of shocks, notably sharp increases in commodity prices and a significant appreciation of the exchange rate, all in the context of continuing global growth.

14. The government is fully committed to fiscal prudence, explicitly based on a target for the central government structural surplus of 1 percent of GDP, which has contributed in strengthening Chile’s credibility in the international financial markets, reducing the spread at which residents can borrow abroad, and allowing automatic stabilizers to function. Furthermore, our authorities are committed to strengthen fiscal transparency and accountability, reflected in the Law of Fiscal Responsibility, which is expected to be approved by Congress during the second half of 2006. The initiative contemplates the legal obligation for future governments to set forth the basis for their fiscal policy during the first 90 days of their administration. In addition, it includes other initiatives such as the creation of a new Economic and Social Stabilization Fund as described in the staff report; the creation and regulation of the Pension Reserve Fund, which will accumulate resources guaranteeing future payments of minimum and assistance pensions due to rise as of 2016; the establishment of rules for the management and reporting of resources from both Funds, and the authorization for the government to make capital contributions to the Central Bank on account of actual surplus.

15. Building on the progress made by former administrations, the new government has emphasized that the focus of it social policy is on both protecting citizens over their life cycle and raising living standards. This safety net starts with childhood protection by removing inequities at birth, enhancing the coverage and facilitating the access to childcare centers, which may result in promoting women’s labor participation. The government has already increased preschool education coverage for 20 thousand children by opening 800 childcare centers. Furthermore, the recommendations of the Advisory Committee for Childhood will be considered in the design of a new childhood protection policy, which will be brought to Congress for its legislative discussion.

16. Similar measures have been taken for the protection of the elderly, including initiatives such as the bills approved in Congress that raised pensions for those over 65 years-old, and guarantees gratuity in public hospitals for all citizens 60 years-old or more. Another initiative, of a more structural nature, and on which the government has put special emphasis on is that of the pension system reform, based on the assessment and recommendations made by the President’s Advisory Committee. In early July the committee issued its report covering 70 reform proposals in 11 areas, whose most important element have been described by the staff in the supplementary note. After an analysis of the report by a committee of ministers, the draft bill is expected to be sent to Congress late this year. The discussion in Congress is expected to take place during 2007.

17. Last but no least, the new government also aims at raising the population’s living standards. Since 1991 the housing defict has been halved with the help of the construction of almost 2 million units. In order to reduce this deficit further by 20 percent over the next four years, the government has recently announced the establishment of a new social housing policy, which intends to raise the standards of construction and design of government-supported houses, and subsidize the housing localization to avoid urban segregation. In a complementary direction, the government plans to take a series of measures to enhance urban security, including increased spending on the police force, and the creation of a Ministry of Homeland Security.

Conclusion

18. In a nutshell, these measures, in the context of a sound and responsible fiscal and monetary policy framework in place, will allow Chile to continue its road to development, by creating the conditions for stronger productivity growth, a key ingredient to sustained economic growth and rising living standards.